Secondary Buyouts — The Ins and Outs

Secondary buyouts occur when private equity (PE) firms sell control of a portfolio company to another PE firm. The transaction seems simple at a glance, but there are several implications tied to this particular kind of deal, both on the buy side and sell side.

Since 2009, there has been a pronounced uptick in secondary buyouts as an exit strategy for PE firms, PitchBook datashow. Last year, secondary buyouts accounted for 40% of all exits (IPOs and corporate acquisitions are considered the other two main exit methods for PE firms), which was down slightly from 2012’s 44%. Only four years ago, however, secondary buyout deals accounted for just 25% of PE exits, which was dwarfed by the “healthy” 64% in corporate acquisitions. Blackstone’s global head of private equity, Joseph Baratta, spoke for many (particularly limited partners) when he noted that the recent boom in secondary buyouts “is not a sign of health in our market.”

For one thing, why would a secondary buyout occur in the first place? If a company has already spent four or five years under private equity control, wouldn’t the initial PE investor have already made significant changes in the company’s direction and business? How much investment upside would a second PE firm have?

Quite a bit, some argue. PE firms differ significantly in what they bring to the table; one firm might be able to expand a portfolio company’s market share through a comparatively strong understanding of a particular industry, or through an exclusive network of industry executives, or even through its own investment portfolio stocked with similar companies. Oftentimes, portfolio companies are sold by smaller PE firms to bigger ones, which would give the company access to more capital (and more expansion opportunities) than the company had with the smaller firm. Clayton, Dubilier & Rice’s Thomas Franco, speaking at Yale’s Private Equity Conference in 2011, noted that “many PE-backed companies are lightly touched under prior ownership, leaving a lot of runway left” for subsequent firms to add value to a portfolio company.

Other companies, for one reason or another, are simply better off staying under private equity control, and are sold between firms when the selling investor needs to cash out and distribute funds back to its limited partners (LPs). Relatedly, secondary buyouts, like corporate acquisitions, provide lump sum payments to selling investors (and their LPs), as opposed to staggered, drawn out exits via public offerings.

Interestingly enough, the loudest critics of secondary buyouts are LPs, the investors that are actually paying for them. One particularly irksome—and not uncommon—scenario is for an LP, by investing in multiple PE funds, to essentially sell itself a portfolio company it already owns. LPs invest their capital into dozens of different private equity funds. When one of those funds decides to sell a portfolio company to another fund also backed by that LP, it’s like an LP’s right hand selling to its left. The wrinkle, of course, is that the transaction doesn’t come without costs for the LP. Fees are tacked onto the transaction, partially diminishing the returns to LPs once the company is ultimately sold to the public market or a strategic buyer.

Are secondary buyouts worth it to LPs? Not necessarily. According to a recent research paper by the Harvard Business School, secondary buyouts “generate much lower average returns for buyers” than primary (initial) buyouts, and distribute “$0.40 less cash per $1.00 of cash invested and … an approximately 15% lower internal rate of return (IRR).” Companies that have gone through multiple secondary buyouts only return 88% of an investment’s net present value (NPV) to investors, while initial buyouts and first secondary buyouts return, on average, higher NPVs upon exit.

Despite a big drop-off (28%) in secondary buyout activity in 2013, the market forces that were in place in 2012, when they accounted for almost half of all exits, are still in place today. “Secondary buyouts have been a powerful trend in recent years,” EY’s Jeff Bunder noted in our recent Private Equity Breakdown report, “and will continue to be an important part of the industry model” going forward.